Tag: QE

The economic impact from Covid-19 has already been unprecedented in its severity and speed, prompting governments across the globe to offer extraordinary levels of fiscal support to ameliorate the impact on households and businesses. As a consequence budget deficits will soar, raising the question of how they will be funded. The fact that some of the additional government spending has come in the form of cash payments to households or direct wage support has prompted references to ‘Helicopter money’, although that is to misunderstand the concept and indeed how these deficits will be funded,which as it stands will be from existing and future tax payers albeit with the caveat that central bank actions can reduce the interest bill.

The term ‘Helicopter money’ was coined in 1969 by Milton Friedman, musing on the impact of a one-off increase in the money supply, in this case via the drop of €1,000 dollar bills from the sky (it would simpy raise prices he thought). More recently the idea re-emerged in the noughties as central banks started to worry about deflation and has also become associated with Modern Monetary Theory or as some call it, the ‘Magic Money Tree’. This contends that money is essentially a fiscal creation and that a government with monetary sovereignty, such as the US or UK, can fund additional spending by printing money rather than through taxes, albeit in the modern world through the central bank simply crediting a balance in the State’s account at the bank. Note that euro member states do not have monetary sovereignty and the ECB is prohibited from monetary financing.

What is striking though is that,to date at least, the huge sums that governments have committed to spend are seen to be funded by borrowing. The partial payment of wages by the State, for example, is no different from the payment to recipients of unemployment or other social welfare i.e. it is a transfer from tax payers, paid out of current tax receipts or from future tax receipts by borrowing.

Consequently, Government debt levels will rise steeply, as in many cases deficit ratios will balloon to double digit levels, although that depends on the duration and severity of the recession unfolding before us. In Ireland’s case the Central Bank (CB) has recently projected an Exchequer deficit around €20bn this year, which if broadly right implies a major increase in debt issuance. That had been put at up to €14bn, against €19bn due for redemption because the NTMA had intended to run down some of its cash balances which amounted to €15bn at the beginning of the year. The implication now is that a €10bn reduction in cash balances would still require around €30bn in issuance of new debt.

The NTMA have already issued €11bn to date and of course the interest rate on the debt is very low, albeit higher than it was a few months ago, so debt is being redeemed and replaced at a much lower cost, reducing the average interest rate on the outstanding debt, which is now down around 2%. QE is helping of course, which allows the ECB and the (CB) to buy up to a third of any issuance and hold up to a third of debt issued. That means that most of the interest on that QE debt is paid to the CB , boosting its income and hence largely returned to the Exchequer as CB profit.

This is not helicopter money as the bonds at issue will have to be repaid, most likley by issuing new debt on redemption, which implies QE will be never ending unless economies are strong enough for private investors to buy all of the new debt issued. There is also an additional contraint on QE in the euro area in that bond buying is broadly proportionate to each member’s population and GDP, which determines the ‘Capital Key’ ( share of the ECB’s capital subscription). In Ireland’s case it is around 1.5%, so Irish government bonds held under QE amount to €34bn out of a total of €2261bn .

The Covid pandemic and resulting economic crisis has prompted the ECB’s new Pandemic Emergency Purchase Programme (PEPP) which does appear to include the capital key constraint but not the issue limit. It is designed to run this year with a size of €750bn and therefore in theory could buy most or all of a new bond. Ireland might issue €15bn in a 30 year pandemic bond, for example, and the ECB could buy say €12bn, with most of the interest therefore paid to the CB. All this helps to reduce interest costs but is not the same as printing money to give to individuals, via bank transfer or from a helicopter.

According to the 2016 census around 1 in 5 of Irish households were in private rented accommodatiom, against under 10% a decade earlier, with the actual numbers more than doubling to over 300,000. Over that period the average monthly rent paid fell by over 20% between 2008 and 2011 before recovering strongly and then pushing to new highs; the 2017 average was €1050 and this year will probably be around €1120 ( the rent actually paid, used here, differs from the asking rent on new lets).

What determines the level of rent? It is generally argued that rents, unlike house prices, are not prone to speculative bubbles, largely because leverage is not involved, and the market is competitive, with a large number of individual renters. So real factors are likely to dominate and in our own rental model two are key. Employment appears to be a big driver of the demand for rental property while the main factor acting to dampen rental growth is the change in the housing stock relative to the population. Consequently, the persistent upward move in rents over recent years is readily explainable, given a backdrop of surging employment and weak house completions, the latter proving too low to prevent the housing stock per head from falling.

As can be seen in the chart, our model tracks actual rents very well, although over the last three years the model is underpredicting, by up to 10% in 2018, which implies something else is at play supporting rental values, particularly as there are now controls on existing rents in the major cities.. In our view there are two factors which together are pushing rents above where they might be given employment levels and housing supply. The first is the Central Bank’s mortgage controls, which were first introduced in 2015 and modified since. The most recent change came into effect this year and reduced the number of mortgages for first time buyers that can exceed the 3.5 LTI limit to 20% from the 25% that had been drawn down in 2017. Income is the key constraint for this segment of the market and the number of mortgage approvals for FTBs fell in the first half of 2018 relative to the final six months of last year. In other words, would be buyers that might have secured a mortgage on the previous criterion are still renting.

In addition, the combination of high rental yields and low returns on traditional lower risk assets ( influenced by QE) have spurred huge investor interest in the Irish rental market, from Reits, pension funds, foreign investment funds and individuals- a third of transactions this year are to non-household buyers or an individual not occupying the property and that share has been above 30% since late 2013.

The rental market will eventually cool as the supply of housing increases ( or if there is an employment shock) but rents appear to be higher than the fundamentals dictate as would- be house buyers have to compete with investors seeking relatively high yields and are also constrained by controls on leverage.

Longer term euro interest rates have moved higher over the past few weeks as the market starts to adjust to what it perceives as an imminent change in monetary policy from the ECB. 10-year German bond yields are trading at over 0.5%, which is still extraordinarly low but compares with a yield of only 0.25% at end-June, so the speed of the move has surprised. A ‘reflation’ reference by Draghi was the initial catalyst ( although later played down by the ECB) and the pace of economic activity has certainly picked up this year but the problem for the hawks in the Governing Council is that inflation remains stubbornly below target (1.3% in June), with the core rate still remarkably low (1.1%).

GDP in the Euro area (EA) grew by 0.6% in the first quarter and strong survey readings (the IFO in Germany is currently at a record high) imply a similar if not stronger figure for q2. On that basis it now seems likely that annual growth in the EA may emerge at 2.1% or 2.2% this year and hence above the 1.9% projected in the June ECB staff forecast. There have only been two previous tightening cycles by the Bank, and the IFO is currently well above the level that has previously triggered higher rates, but , to date, the pick up in economic activity has not put any material upward pressure on prices.

The persistence of low inflation , not just in the EA but across other developed economies, notably the US, has prompted a lot of analysis.What is striking is the behaviour of wages, as they have not responded to tightening labour markets in the expected way. That relationship is generally known as the Phillips curve, and the evidence shows that the curve is now much flatter than in the past i.e. a given fall in unemployment has very little impact on wages. So, for example, EA unemployment has fallen from 12.1% to the current 9.3% but wage inflation in q1 was only 1.4% and averaged 1.5% in 2016.

A range of factors have been put forward for this limp growth is wages; low price inflation, the decline of trade unions, globalisation, the growth of self employment and changes in the structure of the jobs market. Many of these factors are structural and if so, the acceleration in wage inflation expected by the ECB over the next few years may not materialise, despite stronger GDP growth.

The ECB also now tends to emphasise core inflation more than it did under the previous President, but the inflation target is set in terms of the headline rate, and most research shows that to be strongly influenced in the shorter term by commodity prices and the exchange rate. Consequently, the recent fall in oil prices and the appreciation of the euro ( up 8% against the US dollar in the past three months), unless reversed, would normally prompt a further downward revision in the the next ECB inflation forecast in September.The June forecast itself reduced the inflation projection over the next three years by a cumulative 0.6 percentage points, largely reflecting weaker oil prices. Another point worth noting is that credit growth, although stronger than last year, is still anaemic, a factor referred to in the latest ECB minutes.

So what is the market expecting? It would be difficult for the ECB to claim that there are upside risks to inflation but having stated that the risks of deflation have effectively disappeared the Bank may tweak it guidance on asset purchases, which currently states that ‘we stand ready to increase our asset purchase programme in terms of size and/or duration‘. In reality, the scope to increase QE is anyway constrained, as in a number of cases the Bank is at or close to the 33% issuer limit in government bonds. However, the market does not expect an immediate halt to buying by the end of the year, rather a gradual tapering of the monthly total into 2018.

Yet the ECB would find itself in a difficult situation if inflation fell further over the next few months, as it has argued that QE has been instrumental in boosting the price level and that ‘ a very substantial degree of monetary accommodation is still needed for underlying inflation pressures to build up and support headline inflation in the medium term’. The Fed also faces low inflation but can point to its dual mandate ( stable prices and full employment ) to justify tightening, but the ECB does not have that luxury.

Inflation in the euro area has been below 2% now for over three and a half years, and the ECB is currently pulling four policy levers in an attempt to get inflation back up to its target level. The first is forward guidance, adopted by the Governing Council in mid-2013, designed to convince the market that rates will stay lower for longer. The latest wording to that effect states that ‘we continue to expect [rates] to remain at present or lower levels for an extended period of time’ which also flags the possibility of further easing.

In the past the ECB has used official interest rates as its main policy instrument and they are now at historically low levels; the refinancing rate is zero while the deposit rate has been cut to -0.4%. Money market rates are also negative , including 12-month euribor. Forward rates imply that the market does not expect any upward move in official rates till 2019.

Credit in the euro zone is largely driven by the banking sector ( unlike the US, for example) and the ECB has also introduced additional measures to boost bank lending , including offering banks long term loans at very low rates. The latest variant (TLTRO II) offers loans up to four years at a zero rate, and banks can reduce the rate paid into negative territory depending on the growth of their loan book. So the ECB would effectively be paying banks to take funds.

Bank lending to the private sector has picked up but is still very weak by historical standards ( the annual increase is currently 1.7%) and so the ECB has sought to influence spending more directly by its asset purchase programme, the fourth policy instrument currently at play. The current plan is to purchase €80bn a month ‘until the end of March 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim‘

Inflation is currently 0.4% and the ECB’s staff forecast envisages a gradual acceleration to an average 1.6% in 2018. The consensus market view is that further monetary easing is a virtual certainty, although there is some disagreement about the form that might take. It is noticeable that the Governing Council is now expressing more concern about the profitability of the banking system (at least in the minutes of recent meetings) and fewer analysts now expect a further rate reduction in either the refinancing rate or the deposit rate. It is early days yet for the TRLTRO so any change there is unlikely and so we are left with possible tweaks to QE, including a tapering, although, again, there are a variety of views. Some believe that the ECB may broaden the universe of assets purchased, but in reality that means buying bank debt and/or equities, which may be acceptable for the Bank of Japan but is highly unlikely , one would think , given the ECB’s constitutional and operational constraints.

That leaves changes to the current government bond programme, and a majority of analyts believe that the scheme will be extended beyond March, for 6 months or longer. That is not without its problems, however, as in some cases the ECB is at or close to the current 33% issue and issuer limits ( including Ireland) and at various points of late almost half the available bonds have been trading below zero, with a smaller proportion below -0.4% in yield. A decision to leave the deposit rate unchanged would presumably preclude the latter and a decision to up the issue and issuer limits could potentially give the ECB the main role in any default proceedings, an awkward position for a bank regulator. At the moment the bond purchases are also constrained by the need to adhere to the capital key ( purchases are broadly proportional to each country’s weighting in the ECB’s capital) and again a decision to abandon this may prompt opposition fror the ‘German school’ within the Governing council.

What we do know is that various committess have been set up within the ECB to tease out these matters and examine how QE could be extended if required, but the bigger issue is whether the ECB is at or near the end of its monetary policy cycle. The December Staff forecasts will be crucial and it is worth noting that oil prices are now higher , which of itself could push the 2018 inflation forecasts to around 2%. The Council also believes its policies have had a significant effect already are are still working through the system. QE has to end at some point, one would think, and the main issue now is whether it will be in five months or ten.

Inflation in the euro zone has been below 2% for three and a half years now and under 1% for almost two years, with the latest figure for August at 0.2%. Many people would think this a good thing in a period of very modest wage growth, as it supports real incomes, but it is a failure for the ECB , as its goal is price stability, which it defines as inflation close to but below 2%. Very low inflation risks deflation in the Bank’s view and although the inflation trend is heavily influenced by weak commodity prices core measures are also weak: excluding food and energy, inflation was 0.8% in August, indicating very little price pressures.

The ECB was slower than other Central Banks in cutting interest rates but the main refinancing rate is now at zero alongside a negative deposit rate of -0.4%, all designed to encourage banks to lend into the real economy. That approach reflects the importance of banks in the EA as the main providers of credit and the ECB has recently gone further down that particular road, with its latest TLTRO scheme, allowing participating banks to access four-year funds at an interest rate which could fall to the -0.4% deposit rate depending on lending growth. In other words the ECB could end up effectively paying some banks to lend money.

The ECB also decided to by-pass the banking route by embracing QE, with the purchase of government and corporate bonds designed to push down longer term rates. To date , some €1,165bn assets have been purchased, including over €940bn in government bonds, with the programme currently projected to run until March 2017.

Has any of this worked? Growth in the EA is averaging around 0.4% per quarter, hardly stellar, but sufficient to put downward pressure on the unemployment rate, which has fallen to 10.1% from a peak over 12%. Bank credit has also started to rise, from a very weak base, with lending to the private sector growing at an annual 1.7% rate in July and the ECB has been keen to point out that the cost of funds for EA banks in general has fallen steadily as a result of monetary policy decisions.

Yet credit growth is still contracting in many countries, including Ireland, despite ample liquidity. Indeed, data from the Central Bank here shows that in July deposits in Irish banks exceeded loans, a far cry from the 190% loan to deposit ratio seen pre-crisis. This highlights that in some countries deleveraging is still a dominant force and there are other factors at work, including capital issues for some banks, the scale of non-performing loans and the appetite from lending institutions to take on risk.

Negative rates are also an issue, in that they are putting downward pressure on net interest margins; banks are reluctant to cut deposit rates below zero but many of their loans are linked to market rates, which are falling. Initially the ECB was loathe to accept this point, arguing that higher loan growth would be an offset, but in the minutes of the last Council meeting there was concern expressed about the profitability of EA banks and their low stock market valuations, increasing the cost of capital for banks and hence reducing lending.

These concerns may dissuade the ECB from further cuts in the deposit rate and they also face problems with QE, in that the universe of government bonds available for purchase is shrinking, and in some cases the 33% issuer limit is likely to become a binding constraint- that will be the case in Ireland, for example. The ECB could change that limit or extend its purchase of corporate debt, although the latter already moves the Bank into allocating credit directly, which may make some Council members uncomfortable as well as stretching its mandate..

The bigger question is whether all this is having any impact on inflation and the answer would appear to be in the negative. Rather than increasing the bet, the ECB might reconsider its whole approach, with a growing number of policymakers across the globe examining the case for more expansionary fiscal policy. On that point it was notable that the Fiscal theory of the Price Level got an airing at the recent Jackson Hole gathering, with a paper delivered by Princeton’s Christopher Sims, who is closely associate with that approach. The theory is that the price level is influenced by fiscal policy as well as monetary policy, and argues that low interest rates can be deflationary , in that they reduce debt service for governments and unless offset by higher spending or tax reductions will result in contractionary fiscal policy.

Generating inflation in the current environment requires much more expansionary fiscal policy, it is argued, and we may indeed end up with a changed fiscal approach in some countries, including the UK, albeit for different reasons. That appears very unlikely in the EA however, and President Draghi may end up like the legendary Greek king, doomed to push a boulder up the hill only to see it always roll back.

The ECB first cut its deposit rate to negative territory in June 2014, to -0.1%, and reduced it again late that year, to -0.2%, with a third cut taking it to -0.3% in December 2015. A further reduction was announced last month, to -0.4%, and since then criticism of the move has intensified, most notably of late from the German Finance Minister, concerned at the low return for savers. Low and negative bond yields are putting pressure on insurance companies with products offering a guaranteed return and the ECB’s deposit rate is particularly irksome for the hundreds of small savings banks across the Federal Republic, given that retail deposit rates cannot fall below zero.

That squeeze on margins is not an exclusive German phenomenon, of course, and any banking system with a high dependency on retail deposits will be affected. Ironically, perhaps, banks in general have been urged to reduce their dependence on the wholesale markets , and new Basel III rules on liquidity and funding also push banks towards deposits.

The ECB has recently responded to the criticism by arguing that any squeeze on net interest margin can be more than offset by higher loan growth, which the policy is designed to stimulate, and the capital gains resulting from the fall in bond yields. In that context the results of the latest ECB Bank Lending Survey (BLS) for April is instructive, as it includes a number of ad hoc questions regarding the impact of non-standard monetary policy, including the effect of the negative deposit rate. Not one bank felt the deposit rate had a positive impact on their net interest income, with 63% stating a negative impact and another 18% a very negative effect, giving a net negative figure of 81%. Asked about the next six months, the net negative figure climbed to 85%. The vast majority of banks had seen no impact on loan volumes, although there was a small net positive, but this was offset by the negative impact on margins, so reducing overall income.

The survey also asked respondents about the impact of the ECB’s asset purchase programme, and again the results are unlikely to raise too much cheer in Frankfurt. A small net number of banks (4%) had sold sovereign bonds as a result of QE and those experiencing capital gains in general on assets for sales was a net positive 12% but that benefit was also more than offset by the net interest margin impact, with a net 27% seeing a fall in NIM. The result was that only 9% of banks had seen profitability rise as a result of QE, with 28% experiencing a profit fall, leaving a net decline percentage of 19%.

On the positive side QE was seen to have improved the liquidity position of banks and access to financing, notably via covered bonds, and the ECB has of late highlighted these metrics as a sign that non-standard measures are working. Credit to the private sector is also finally growing again, albeit by an annual 0.9% , but for the moment at least the evidence supports the view that negative rates, in particular, are having a detrimental effect on bank profits. It remains to be seen how that will change when the ECB’s long term loan scheme comes on stream.

Quantitative Easing is generally seen as being negative for the currency in question, and the evidence would seem to support this, albeit not in all situations (sterling, for example). The ECB certainly believes that to be the case, the rationale being that lower bond yields in the EA will prompt investors to seek higher returns abroad, so resulting in portfolio outflows and hence selling of the single currency. The euro has certainly depreciated, both in broad trade weighted terms and against the other majors, and in May was 9.5% below its trade weighted value a year earlier, incorporating a 19% fall against the US dollar and a 12% decline against sterling.

Yet we also know that short-term currency moves can be strongly influenced by speculative positioning, with traders shorting a currency in the belief that QE should be negative for its FX value, which then sets up something of a self-fulfilling prophecy for a time , as any initial weakness then prompts further selling given that momentum trading appears to be the predominant style at the moment. Data in the Commitment of Traders weekly report from the CFTC ( incorporating FX futures ) provides a useful guide to speculative positioning, and from that it is clear that the market started to build a very large short position in the euro/dollar last autumn and one which increased further following the QE announcement in January. The position peaked at a record high in late March, at the equivalent of €28bn, and has unwound sharply since to currently stand at €11bn, the lowest in almost a year. So the initial fall in the euro and recent recovery would seem to owe something at least to speculative trades. It is also worth noting that the unwind of the euro shorts coincided with a strong increase in short yen positions and a fall in the yen against the US dollar.

What about more fundamental drivers of the euro, as captured in the Balance of Payments? The first point to note is that the EA runs a current account surplus, largely reflecting a positive merchandise trade balance, and one which is growing; the surplus rose to €212bn in 2014 and amounted to €245bn in the twelve months to April 2015, the latest data available. That surplus would therefore generally put upward pressure on the currency unless offset by capital outflows, which brings us back to the ECB’s hope that QE will stimulate such flows.

There has certainly been a significant change in terms of net portfolio flows. with a net outflow of €160bn in the twelve months to April 2015, against a net inflow of €50bn in the year to April 2014. Moreover, outflows do indeed tend to be in terms of bond purchase, with EA buying of foreign debt instruments amounting to €119bn in the first four months of this year alone, which alongside some modest selling of other assets resulted in a rise in total portfolio outflows of €109bn. Yet QE has also been associated with a significant rally in European stock markets, and the same period has seen portfolio inflows of €76bn, including €96bn in equities. So since the announcement of QE the outflow from debt investors has been offset to a fair degree by the inflow from equity investors albeit still leaving a net portfolio outflow of €33bn in the four months to end-April.

Direct investment flows also matter, however, and here again the first four months of 2015 have seen strong inflows, amounting to €86bn, offsetting outflows of €35bn to give a net inflow figure of €51bn. So net capital flows in total (portfolio plus direct) are small to date this year and actually a net positive (€19n) which added to a cumulative current account surplus of €69bn implies a inflow of €88bn. The errors and omissions on the BOP data can be very large and there are other financial flows associated with the banking sector but on the basis of the available figures it is difficult to build a case that QE has led to the flows anticipated by the ECB or on a scale which might have led to a significant euro weakness. It is early days yet, of course, and higher US rates later in the year may trigger greater bond outflows, or indeed an outcome from the Greece negotiations which is seen as negative for the single currency.

The ECB has been delighted with the response to its asset purchase programme, and indeed the initial reaction from all asset classes, from bonds through to equities and FX, was both significant and supportive of the Bank’s attempts to stimulate economic activity. The ECB first announced its intention to buy private sector debt last September, with the euro trading at $1.29, and the single currency subsequently declined to under $1.05 following the January decision to extend QE to government bonds and the commencement of purchases in early March. European stock markets rose sharply in the months after the January decision and bond yields continued the trend decline begun last autumn; Irish 10-year yields fell to a low of 0.65% and the German equivalent traded at 7bp, with negative yields prevalent in that market up to an including the 5-year maturity.

The picture looks rather different today. Government bond yields have risen sharply amid very volatile trading, with 10-year yields in most markets back up to levels seen last October. German 4 and 5-year yields are now positive again and the major European equity markets have fallen by around 10% from the highs, with the euro also gaining ground, trading above $1.12. QE is still proceeding according to plan and the ECB’s balance sheet is expanding as intended ( €2.42 trillion at end- May from €2.15 trillion at end-2014) so the fall in asset prices has prompted some puzzlement, with a number of explanations vying for supremacy.

One approach emphasizes bond fundamentals, starting with real interest rates and the outlook for economic growth. The macro data in the euro zone has tended to surprise to the upside in recent months and there was some modest upward revisions to near-term growth forecasts but the consensus projections for the next few years have not really changed, with most still expecting a sub 2% expansion in the EA. Similarly the outlook for the global economy has not materially changed (if anything, the growth forecast for this year have moved lower) so it does not seem likely that real interest rates have suddenly moved higher.

Nominal bond yields are also determined by inflation expectations (plus a risk premium) and again forecasts for EA inflation have not materially changed of late, including those from the ECB, which foresees a gradual return to annual inflations rates approaching 2%. Actual inflation has turned positive, it has to be said, so perhaps the deflation scare has abated, although it was always difficult to know if that was really a major concern for investors. Expectations on one of the ECB’s most closely watched measures (the 5 year five year forward inflation swap) are around 1.75%, which is well up from the sub 1.50% lows but not signaling any inflation scare.

Some peripheral bond markets have fared worse than others during the sell-off (Portugal for example) but a generalized contagion from Greece is not evident, at least not yet, given that 10-yr bund yields have also risen sharply, by over 80bp in the past 6 weeks.

Other explanations emphasis market conditions. Issuance in some markets has been higher than expected, for example, including corporate debt. Lack of liquidity may also be a factor, as a consequence of banks having to hold more regulatory capital. This , alongside the Volckler rule, has persuaded many market-makers to hold less inventory, with the result that a given degree of selling will have a much greater impact on the market price than it would have done a few years ago. Certainly the scale of intra-day volatility (up to 16bp in 10-year bund yields) is far higher than normal, supporting the idea of thinner markets.

Another explanation highlights the different types of bond buyers, each with varying risk tolerances and trading objectives. Banks are required to hold more liquid assets under new Basel regulations, and so have bought shorter-dated bonds even at negative yields , particularly as for some the alternative is a deposit with the ECB at an interest rate of -0.2% (overnight ECB deposits are still high, at €100bn). Credit conditions are improving in the EA, however, with a modest pick up in lending to the private sector, so some banks are finally using the ample liquidity available to support credit creation to firms and households.

Hedge funds and other traders are looking for a short term return and here the predominant trading style may be a factor- momentum trading is the order of the day for many, which explains why a trend already well established can persist long after some feel it has lost touch with fundamentals. The problem arises when the trend changes and many are then heading for the door, which is suddenly crowded. The lack of liquidity is exacerbating the downdraft.

‘Real money’ investors, such as pension and insurance funds, are also important, but usually ‘buy-to-hold’ and generally players at longer maturities. They are therefore less likely to get caught up in a specific trading style and may well step in following a sharp sell-off, so putting a floor in the market.

All these explanations, fundamental and market related, are not mutually exclusive, of course, and I suspect the sell-off owes most to the recent inflation data and the acceleration in monetary growth, with the exit from a crowded trade also playing a big role. One should also keep the correction in perspective- bond yields (government and corporate ) are still extremely low by normal standards and hence nominal financial conditions remain unusually loose, even if a little tighter of late. In the shorter term it may well be the actions of the Fed, rather than the ECB, that helps determine the next big move in EA yields.

Negative bond yields are no longer a rarity across the Euro area, accounting for over half the government debt at issue in some countries (Germany, the Netherlands and Finland) and well over a third in others (Austria, France and Belgium). Moreover, what was generally confined to shorter term debt is now extending along the yield curve, and many now expect German 10-year yields (currently 0.15%) to follow Switzerland into negative territory.

Low bond yields are one thing but negative yields are a rare if not unique phenomenon. The former may be generated by a flight to quality but if widespread imply that investors expect short term interest rates to stay low for a long time. That in turn signals an expectation of limp growth and little or no inflation for a prolonged period. Nonetheless, very low yields still mean a positive return, albeit a limited one: if I buy the German 10-year benchmark, which pays a coupon of 0.5% per annum, I will receive €5 per €100 invested in interest , offset by the capital loss on the bond ( it is trading at €103.35). This will reduce my total return over 10 years to just €1.65.

That level of nominal yield is obviously very problematical for savers or for the pension funds that are investing the savings of companies or households. That meagre return is also nominal, of course, and would mean a substantial loss in real terms even with very low inflation over the period.

Nonetheless, any holder to maturity will not face a nominal loss, in contrast to that awaiting an investor with the same time horizon buying a bond at a negative yield . Take the 2% Jan 2022 Bund, which is priced at €113.80. Over the 6.7 years to maturity the interest will amount to €13.40 but this will be offset by the capital loss of €13.80, ensuring a negative nominal return.

Why would anyone buy a bond which gives a loss if held to maturity? Some argue that investors are now simply buying on the expectation that someone else will buy it at a higher price, a classic bubble, but there are other explanations. In the Swiss case investors may believe that the currency will appreciate significantly, so ensuring a positive return for a non-Swiss buyer. One doubts if many expect the euro to outperform most of the other major currencies, however, so other factors are at work. One is QE, in that the ECB is a buyer in the market at any yield above -0.2%. The ECB will not buy all the bonds at issue, however,( the limit is 33% , at least for now) so investors will still be left holding two-thirds of the market.

A second rationale relates to banks, the main buyers of shorter-dated bonds. For them, any excess liquidity deposited with the ECB costs them 0.2% so any yield above that, even if negative, is viewed as a plus. The implication is that banks would also prefer to park liquidity in bonds, however low the yield, than lend it to firms or households – such lending requires higher capital backing and in general carries a higher perceived risk. One should also remember that banks are also now required to hold a specified amount of assets in liquid form, as part of the Basel 111 regulatory changes, which in effect means a greater demand for government bonds at the same time as the ECB has entered the market as a buyer.

For investors as a whole the low or even negative return on bonds is supposed to act as an incentive to switch to other assets, including equities and corporate debt, although again, regulatory constraints for pension funds and insurance companies may make a significant switch into riskier assets problematical.

In the short term, then, a combination of QE and pessimism on growth and inflation has led to a collapse in the risk free rate of return, with the possibility of 10-year yields and beyond turning negative. That has serious practical implications for savers and those relying on annuities in retirement. At another level, it throws up difficulties for asset valuation models, as the risk free alternative is now a negative number. How all this ends is anyone’s guess but there is a paradox at its heart; if QE stimulates growth and leads to a rise in inflation over the medium term, perhaps due to a much weaker currency, it makes negative bond returns in real terms all the more likely for anyone buying to hold at these levels.

The ECB’s expanded QE is due to start in March and a figure of €12bn is often reported in terms of the amount of Irish sovereign debt that the Central bank can buy. The case is not that clear-cut , however, and the limit may be only €9bn from June.

Bonds purchased in any EA country under QE are subject to a number of restrictions. The first limits the share of the total each country can buy. In Ireland that means about 1.7% of the €60bn per month QE target, which includes private and EU supranationals as well as government debt. The second limits central bank buying to 25% of any issue. A third puts a 33% ceiling on the amount of any issuer’s debt that can be held . The latter only makes sense relative to the 25% limit if existing central bank holdings are included .

Indeed,the ECB does already own some sovereign debt, purchased under the Securities Market Program (SMP) , which stands at €144bn having fallen from over €200bn (via bonds maturing). We do not know the current breakdown of that holding by country but the ECB did publish that data as at end-2012. At that time €14bn of Irish government debt had been purchased, 6.5% of the then total, which implies about €9bn today, assuming redemptions were broadly proportional over the past two years.

The Irish Central Bank also owns government debt stemming from the Anglo Promissory note. Part of that was repaid in 2012 via the issuance of €3.5bn of the 5.4% 2025 bond. The Bank announced it had sold a portion of that in 2013 but presumably still owns around €3bn of that issue. In addition, the Central bank received €25bn in long term bonds as part of the Promissory note deal in 2013 and again has sold a small amount, leaving €24.5bn.

Another QE stipulation is that only bonds with a maturity between 2 and 30 years are eligible, which in Ireland’s case gives a current figure of €86bn. That implies €8.5bn of central bank holdings are within that range ( including €5.5bn of the Prom note bonds) which alongside the €9bn SMP figure gives €17.5bn or 20% of the total at issue. The issue limit therefore leaves only 13% open to further purchase, which is just under €11bn

Finance Minister Noonan stated that the Central bank had ‘ample room ‘ to purchase Irish debt. However, the situation changes in mid-year as €3bn of the Prom note bonds redeem in June 2045 (i.e. would then fall within the 30 year limit), so from then on the CB’s eligible holdings rise to €20.5bn or 23% of the total, implying less than €9bn could be added.

Some SMP holdings will mature over the next 18 months and the Central bank will sell some of its Prom note bonds, so giving some room for additional QE, The NTMA will also issue new debt (perhaps another €11bn this year) which will qualify as long as it is over 2 years so raising the remaining limit for the Central bank rule. Perhaps not quite as ‘ample’ then as some think, in the short term and with more moving parts.